INTRODUCTION OF DERIVATIVES

The emergence of the market for derivative products, most notably forwards,
futures and options, can be traced back to the willingness of risk-averse economic
agents to guard themselves against uncertainties arising out of fluctuations in asset
prices. By their very nature, the financial markets are marked by a very high
degree of volatility. Through the use of derivative products, it is possible to
partially or fully transfer price risks by locking-in asset Prices. As instruments of
risk management, these generally do not influence the Fluctuations in the
underlying asset prices. However, by locking-in asset prices, Derivative products
minimize the impact of fluctuations in asset prices on the Profitability and cash
flow situation of risk-averse investors.

Derivatives are risk management instruments, which derive their value from
an underlying asset. The underlying asset can be bullion, index, share, bonds,
Currency, interest, etc., Banks, Securities firms, companies and investors to hedge
risks, to gain access to cheaper money and to make profit, use derivatives.
Derivatives are likely to grow even at a faster rate in future.

DEFINITION OF DERIVATIVES

“Derivative is a product whose value is derived from the value of an underlying

asset in a contractual manner. The underlying asset can be equity, Forex,
commodity or any other asset.”

 Securities Contract ( regulation) Act, 1956 (SC(R) A)defines “debt

instrument, share, loan whether secured or unsecured, risk instrument or
contract for differences or any other form of security”
  A contract which derives its value from the prices, or index of prices, of
underlying securities.
THE GROWTH OF DERIVATIVES MARKET

Over the last three decades, the derivatives markets have seen a phenomenal
growth. A large variety of derivative contracts have been launched at exchanges
across the world. Some of the factors driving the growth of financial derivatives
are:

 Increased volatility in asset prices in financial markets,

 Increased integration of national financial markets with the
international markets,
 Marked improvement in communication facilities and sharp decline in
their costs,
 Development of more sophisticated risk management tools, providing
economic agents a wider choice of risk management strategies, and
 Innovations in the derivatives markets, which optimally combine the
risks and returns over a large number of financial assets leading to
higher returns, reduced risk as well as transactions costs as compared
to individual financial assets.
DERIVATIVE PRODUCTS (TYPES)

The following are the various types of derivatives. They are:

Forwards: A forward contract is a customized contract between two entities,

where settlement takes place on a specific date in the future at today’s pre-agreed
price.

Futures: A futures contract is an agreement between two parties to buy or sell an

asset at a certain time in the future at a certain price. Futures contracts are special
types of forward contracts in the sense that the former are standardized exchange-
traded contracts.

Options: Options are of two types-calls and puts. Calls give the buyer the right
but not the obligation to buy a given quantity of the underlying asset, at a given
price on or before a given future date. Puts give the buyer the right, but not the
obligation to sell a given quantity of the underlying asset at a given price on or
before a given date.

Warrants: Options generally have lives of upto one year; the majority of options
traded on options exchanges having a maximum maturity of nine months. Longer-
dated options are called warrants and are generally traded Over-the-counter.

Leaps: The acronym LEAPS means Long-Term Equity Anticipation Securities.

These are options having a maturity of upto three years.

Baskets:Basket options are options on portfolio of underlying assets. The

underlying asset is usually a moving average of a basket of assets. Equity index
options are a form of basket options.
Swaps: Swaps are private agreement between two parties to exchange cash flows
in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are:

 Interest rate swaps:

The entail swapping only the interest related cash flows between the parties in the
same currency.

 Currency swaps:
These entail swapping both principal and interest between the parties, with the
cashflows in one direction being in a different currency than those in the opposite
direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative
at the expiry of the options. Thus a swaption is an option on a forward swap.
Rather than have calls and puts, the swaptions market has receiver swaptions and
payer swaptions. A receiver swaption is an option to receive fixed and pay
floating. A payer swaption is an option to pay fixed and received floating.
PARTICIPANTS IN THE DERRIVATIVES MARKETS

The following three broad categories of participants:

HEDGERS: Hedgers face risk associated with the price of an asset. They use
futures or options markets to reduce or eliminate this risk.

SPECULATORS: Speculators wish to bet on future movements in the price of an

asset. Futures and options contracts can give them an extra leverage; that is, they
can increase both the potential gains and potential losses in a speculative venture.

ARBITRAGEURS: Arbitrageurs are in business to take advantage of a

discrepancy between prices in two different markets. If, for example they see the
futures prices of an asset getting out of line with the cash price, they will take
offsetting positions in the two markets to lock in a profit.
INTRODUCTION OF FUTURES

Futures markets were designed to solve the problems that exist in forward markets.
A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. But unlike forward contract, the futures
contracts are standardized and exchange traded. To facilitate liquidity in the
futures contract, the exchange specifies certain standard features of the contract. It
is standardized contract with standard underlying instrument, a standard quantity
and quality of the underlying instrument that can be delivered,

(Or which can be used for reference purpose in settlement) and a standard timing
of such settlement. A futures contract may be offset prior to maturity by entering
into an equal and opposite transaction. More than 90% of futures transactions are
offset this way.

The standardized items in a futures contract are:

 Quantity of the underlying

 Quality of the underlying
 The date and the month of delivery
 The units of price quotation and minimum price change
 Location of settlement

DIFINITION

A Futures contract is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded
contracts.
FEATURES OF FUTURES

 Futures are highly standardized.

 The contracting parties need not pay any down payment.
 Hedging of price risks.
 They have secondary markets too.

TYPES OF FUTURES

On the basis of the underlying asset they derive, the futures are divided into two
types:

 Stock Futures
 Index Futures

PARTIES IN THE FUTURES CONTRACT

There are two parties in a futures contract, the buyers and the seller. The buyer of
the futures contract is one who is LONG on the futures contract and the seller of
the futures contract is who is SHORT on the futures contract.

The pay-off for the buyers and the seller of the futures of the contracts are as
follows:
PAY-OFF FOR A BUYER OF FUTURES

P
PROFIT

E 2
F E 1
LOSS

Figure 2.1

CASE 1:- The buyers bought the futures contract at (F); if the futures

Price Goes to E1 then the buyer gets the profit of (FP).

CASE 2:- The buyers gets loss when the futures price less then (F); if

The Futures price goes to E2 then the buyer the loss of (FL).
PAY-OFF FOR A SELLER OF FUTURES

P
PROFIT

E2
E 1 F

LOSS

Figure 2.2

F = FUTURES PRICE

E1, E2 = SETLEMENT PRICE

CASE 1:- The seller sold the future contract at (F); if the future goes to

E1 Then the seller gets the profit of (FP).

CASE 2:- The seller gets loss when the future price goes greater than (F);

If the future price goes to E2 then the seller get the loss of (FL).
PRICING FUTURES

Pricing of futures contract is very simple. Using the cost-of-carry logic, we

calculate the fair value of a future contract. Every time the observed price deviates
from the fair value, arbitragers would enter into trades to captures the arbitrage
profit. This in turn would push the futures price back to its fair value. The cost of
carry model used for pricing futures is given below.

F = SerT

Where:

F = Futures price

S = Spot Price of the Underlying

r = Cost of financing (using continuously compounded Interest rate)

T = Time till expiration in years

e = 2.71828

(OR)

F = S (1+r- q) t

Where:

F = Futures price

S = Spot price of the underlying

r = Cost of financing (or) interest Rate

q = Expected dividend yield

t = Holding Period